Private equity

April 2015 | ROUNDTABLE | PRIVATE EQUITY

Financier Worldwide Magazine

April 2015 Issue

In 2014, buyouts and exit activity reached levels unseen for some time. Private equity houses now appear more stable, with record levels of dry powder on hand, and the industry has contracted to a level that anticipated deal flow can comfortably support. But significant challenges remain for GPs and LPs alike. As we move toward the second half of 2015 the fundamental question is: can the private equity industry continue its rebound while meeting the increasing demands of investors and regulators?

FW: In your opinion, what have been the most significant trends in the private equity industry over the last 12 to 18 months?

Dinamani: 2014 was an eventful year for private equity deal activity in Europe, although not in the manner anticipated at the start of the year. Predictions at the time were focused on an upsurge of acquisitions by private equity due to the extensive amount of dry powder funds committed to private equity funds but not yet drawn down, and the likely need for private equity houses to deploy this capital before investment periods on their latest funds expired. Asset prices continued to rise during 2014 as a result of strong demand, both from institutional money looking for new listings in the equity capital markets and from large corporates using their cash piles to make strategic acquisitions. While there were a number of notable acquisitions, including EQT’s acquisition of Bureau van Dijk from Charterhouse and Apax’s public takeover of Exact, private equity houses therefore focused their efforts in 2014 on maximising returns on their existing investments and largely stayed away from bidding for assets at prices which only made sense if the buyer was able to realise significant synergies.

Memminger: There has been a clear rebound in private equity activity over the last 12-18 months. We saw more deals, also bigger deals, hence 2014 was a very good year for private equity in Germany and abroad. Although everyone has been waiting for this to happen for years, it is nevertheless surprising, given how much political instability we saw in 2014 in Europe and elsewhere. But the deal flow suggests that players acted very rationally, analysing the impact of this instability on the deals that were done, which in most cases were rather limited.

Lavery: There have been a number of deals, with the primary factor being the increased level of optimism within the industry. More deals have been done in the last 12-18 months and many more of those deals have been new money transactions, secondary and tertiary deals and exits for real value. The number of distressed transactions is diminishing as the wall of debt with which the industry has struggled for the last five years has been overcome. The private equity houses themselves are now more stable and the industry looks like it has contracted to a level that the anticipated deal flow can support.

Elvin: 2014 was a successful year for private equity, with net returns to investors ahead of all other asset classes over three, five and 10 years, and second only to listed equities over the most recent 12-month period – quite a feat at a time of strong equity markets. The historical pattern of private equity delivering superior returns to investors seems to be established and persisting. It may therefore be hardly surprising that private equity continued to grow, reaching an all-time record of $3.8 trillion AUM in June 2014, an increase of 9.3 percent on June 2013. The biggest story of 2014 was undoubtedly the continued strong distributions back to LPs, as their GPs have used the favourable market conditions to exit many portfolio investments. The 12-month period to December 2013 and the six-month period to June 2014 saw the highest ever distributions to LPs, at $580bn and $450bn respectively, nearly $200bn ahead of capital calls over each period.

Abelow: There are many trends continuing to play out: the decline of the going-private transaction as a meaningful portion of PE deal flow, in part driven by the emergence of activist investors, the increased importance of operating expertise and improvements in generating returns, the shift in who provides credit to the middle market, and the increased market power of the ‘elite’ middle market investment banking firms as the bulge brackets retreat from the market. But we believe that one of the most interesting trends is the one that has been playing out for years, but is still in ‘early innings’ – the emergence of real alternatives to the traditional PE limited partner model for capital formation. The challenge to the old model has been coming in a variety of forms, but includes the direct investing model at major pension funds, the emergence of ever more sophisticated family offices, the creation of PE limited partnerships with longer-than-usual investment horizons, and the emergence of hybrid PE-family office models. All of these types of firms have played significant roles in many of the M&A processes we have run in recent months.

Downey: From a private funds perspective, the most significant trend has been the ongoing shift toward separate managed accounts, co-invest vehicles and other tailored vehicles established to meet the specific demands of LPs. These non-traditional structures are becoming increasingly prevalent across all assets classes, driven initially by credit and infrastructure and now finding traction in the PE space. Credit, energy and infrastructure funds have been the dominant products and we have also seen resurgence in the venture capital space both in Europe and the US, with venture capital returns reported to be some of the highest of 2014.

While firms are searching for an exclusive transaction with no competition from other players, they accept that auctions run by investment banks or other advisers are the predominant source of transactions.

— Dr Peter Memminger

FW: To what extent are private equity firms finding it challenging to source assets for quality deals? Are there any particular sectors that private equity firms seem to be targeting? If so, what are the underlying drivers?

Lavery: In terms of sourcing quality assets, private equity houses face the same issue as always in that a quality asset will attract a great deal of attention. Differentiation has become increasingly important for private equity houses, whether that is as simple as verifiable sector knowledge or the level of strategic or operational support that they can offer an investee company. Over the last 12-18 months, and until very recently, there has been a great deal of focus by private equity houses on the energy and oil & gas sectors, driven by climate change issues and the real potential of fracking. The sharp fall in the price of a barrel of oil may well dent the industry’s enthusiasm for this sector, but old hands will know that potentially good transactions can be done in industry sectors that are going through tough times.

Elvin: There is ongoing concern that high dry powder levels are increasing competition for deals, making it harder for GPs to find attractive investment opportunities which may ultimately impact returns. Sixty percent of buyout managers, 44 percent of growth managers and 39 percent of venture capital managers we surveyed at the end of last year confirmed that they had seen a rise in competition for transactions compared to 12 months ago. Although strong deal flow provides some evidence that the asset class is managing to deal with the overhang, given that GPs are armed with readily available capital, competition for the best deals in 2015 is likely to remain rife.

Abelow: The pricing environment has been and continues to be very good for sellers, and conversely, bad for buyers. However, overall deal quality is fairly good and better, it seems, than it was a year or so ago, at least in the middle market. It wasn’t that many months ago that a lot of middle market cash flow growth was coming from cost-cutting, which has a natural existential limit on sustainability and on how much credit a buyer will give for it. Now it seems as though genuine revenue growth is on display again. A number of sectors, such as healthcare, are emerging from clouds of regulatory or similar uncertainty. This is allowing private capital to support structural change in these areas.

Memminger: I would not say that it is the assets that are missing; rather, it is the sellers that are willing to sell these assets at a price which the average private equity player finds attractive. On the other side, as one private equity player who is active in the industry now for more than 25 years told me, the complaint about the limited number of good-priced assets has always been there, and private equity has succeeded tremendously nevertheless. What you were able to observe over the last 12-18 months is that buyers have accepted that the high price levels won’t disappear soon, and they may even be justified given the availability of debt financing at very attractive terms and because of the good economic outlook.

Downey: There is increasingly acute competition for deals in the European PE market. There were 808 private equity deals in Europe in 2014, up from 767 in 2013, so competition remains fierce. The significant inflow of capital to PE managers over recent years from a combination of new raisings and significant returns on the 2003-2010 vintages, accompanied by the availability of cheap leverage, is putting ever-increasing pressure on GPs to deploy, further pushing up prices and increasing the number of deals going to competitive auction.

Dinamani: It seems to us not that there is a challenge to source quality assets, but rather to source those assets in circumstances where private equity is not outbid by strategic buyers looking to deploy their large cash piles and provide a high price by sacrificing part of their synergies against value – something which private equity is generally unable to do unless they happen to have synergies with an existing portfolio company. The M&A deals in 2014 were characterised by this trend, but that is not to say that private equity firms were not active in making acquisitions – often they were secondary transactions. We expect that private equity houses will continue to spend more time obtaining the inside track on potential acquisitions by staying close to management teams. In terms of sectors, it is largely a case of looking at where growth is likely to be highest, whether due to one-off issues such as regulatory change or more enduring trends. Healthcare and technology look interesting.

FW: How would you characterise the supply of credit and the terms on which it is provided for leveraged buyouts? What debt multiples, and debt-to-equity ratios, are you seeing in the current market?

Downey: There is a considerable focus at present on the rising levels of leverage available in the PE market. The Bank of England recently noted that leverage was nearing US levels at around 5.5 times, and has launched a review of the market. However, recent years have also seen a rise in alternative sources of PE lending from credit funds. Whilst these were, at least in part, initially borne out of a shortage of bank leverage following 2007, they have rapidly evolved into a new asset class as pension funds, insurance companies and others continue the search for yield.

Memminger: Debt has been available for deals at almost every size and kind, except for straightforward insolvency transactions. Terms and conditions are as borrower-friendly as they have been in peak times and there is currently no sign that this may worsen for borrowers in Germany in the near future. We see debt-to-equity ratios of around 70:30 and debt multiples usually between 4 to 6 times EBITDA.

Dinamani: At present the supply of credit is good. Terms are moving in favour of private equity sponsors. We are seeing an increase in covenant-lite loans and the convergence of term loan B and bond covenants in larger credits. In the mid-market, we are seeing only one or two financial covenants, typically net leverage and maybe one of cashflow cover or interest cover and the loosening of add-on acquisition controls. Stretched all senior deals, at 4.5 or 4.75 times, are possible for good large and medium credits. Also, 4.5 times senior loan or bond plus and additional 1 times of junior debt are available for good large and medium credits. Minimum equity for loan deals is in the 30 to 40 percent range and for bond deals at a percentage in the mid-to-low 20s. In practice, the amount of the equity contribution is driven by the need to make a competitive bid rather than the minimum equity levels required by the financiers. The other important trend is the growth of unitranche and the gradual increase in size of unitranche deals – which is all part of the growth of non-bank lenders in the market. Non-bank lenders are not set up to monitor loans in the same way as banks – if the loan underperforms they may just sell it – which explains the convergence of loan and bond terms.

Lavery: The debt market has become more liquid and competitive over the last 6-12 months with the banks responding positively to the more flexible, perhaps aggressive, approach of the direct lending funds. We have even seen collaboration between banks and the direct lending funds on transactions and documentation. The banks are more prepared to negotiate lower margins and fees, around 20-25 bps, and for the larger deals we are seeing covenant-lite documentation on a regular basis. The liquidity in the market has led to slightly higher leverage multiples being supported. Typically, senior A loans have hovered around the 4 percent mark and that could drop lower in 2015. Term loan B margins are between 3.75 to 4.5 percent with unitranche at around 6 percent, secured high yield bond at 6.25 percent and mezzanine at 9 percent.

Regulatory reforms have been a hot topic in the industry of late, as well as a source of confusion, given the uncertainty of impact, complicated laws and frequently delayed implementation dates.

— Christopher Elvin

FW: What strategies are private equity firms employing to complete deals in the current market? Have any recent buyouts caught your attention?

Elvin: Leveraged buyouts continued to be the most dominant type of private equity-backed deal in 2014, accounting for 42 percent and 57 percent in terms of number and aggregate value of all transactions, respectively. Although six of the top 10 private equity-backed deals in 2014 were LBOs, the largest LBO –the acquisition of Gates Global Inc. – falls behind two add-on deals and a take-private transaction. Private equity-backed add-on transactions contributed nearly one-fifth of the aggregate value of all private equity-backed deals in 2014, compared to 15 percent the year before. In contrast, public-to-private deals witnessed a substantial drop in the market share attributed to such transactions in comparison to 2013. In 2014, public-to-private deals accounted for 1 percent of all private equity-backed investments in terms of number and 10 percent in terms of aggregate value. This is in comparison to 2 percent and 29 percent respectively the year before. Such a substantial decrease can be explained by the lack of blockbuster public-to-private takeovers, such as the 2013 acquisitions of H.J. Heinz and Dell Inc.

Abelow: Funds continue to specialise more. Once firms have some real industry expertise and presence, they can deploy a whole slew of tricks – operating executives, stables of add-on acquisitions already romanced, joint venture partners in the wings – to help rationalise today’s high prices. While the old LBOs of the 1980s are now of only historical interest, we have recently seen a number of transactions where buyers weren’t afraid to buy a company knowing that they would likely prune its business portfolio materially shortly after purchase. Also, private equity business development seems to now be an entire occupational category summoned out of whole cloth over the past few years, with more and more middle market funds systematically canvassing the market and their friendly neighbourhood investment banks. Finally, more firms seem willing to make minority investments, or at least to engage in serious minority investment discussions, as a way to bridge towards a control deal.

Lavery: The private equity houses are investing an increasing amount of time and effort in identifying potential transactions early. More time is being spent on winning the hearts and minds of management at an early stage with a view to creating a clear strategy for the anticipated investment period. The hope is that this will give a private equity house an edge which may enable them to accelerate the transaction and short cut the auction process. The fact that private equity houses are becoming more risk averse is also impacting on the number of follow on transactions being pursued through portfolio companies. What was once a relatively uncommon strategy of ‘buy and build’, used where there were obvious economies of scale, is now being applied on a much broader and more sophisticated basis.

Memminger: You can observe that we again have a wide variety of transactions taking place, so one can almost say we are back to normal – except maybe for the fact that the number of €1bn-plus buyouts and the overall number of transactions is still somewhat behind where it had been before 2008 levels. Accordingly, private equity firms are more like normal, and so is the way they are sourcing and executing deals. This means that, while firms are searching for an exclusive transaction with no competition from other players, they accept that auctions run by investment banks or other advisers are the predominant source of transactions, and hence need to follow that path in order to do transactions. One noteworthy transaction is the acquisition of the Flint Group by Goldman Sachs and Koch Industry, not only because of its size, at a transaction volume well above €2bn, but also because of the fact that a private equity player teaming up with a strategic buyer reminds us of what was far more common in large transactions before the financial crisis.

Dinamani: Different houses employ different strategies, which depend very much on their approach. Private equity houses which specialise in carve-outs are having a good time given the number of strategic acquisitions which have mandatory disposal requirements, with the private equity houses in such circumstances able to focus on speed and competence of execution as a key selling point instead of price. The main buyout funds continue to focus on price, with an investment professional describing to me the concept of “creating value through complexity” which I thought was very interesting. Other strategies tend to be deal specific, with private equity being able to take views on execution and risk which strategic buyers either cannot, or cannot within the timeframe.

FW: In terms of boosting portfolio company value and improving returns on exit, how important is it in today’s market to have tangible resources and operational expertise?

Lavery: Market volume for private equity houses is unlikely to ever reach the levels that we saw in 2003 to 2008. The industry itself has downsized to reflect that, but competition for the really quality assets has never been greater and as a consequence differentiation is becoming a critical factor in becoming a preferred bidder in auctions. Private equity houses can no longer be passive during the investment period, simply delivering occasional pieces of strategic financial advice. Corporate sellers and management now expect a great deal more from financial investors in terms of identifying a strategic vision and providing real operational support going forward. That support may be in managing a rolling acquisition program, including post acquisition integration or bringing additional skill sets to a management team from other industries.

Abelow: Today’s robust leverage markets make it more important than ever to have a differentiated operating plan for a company to be acquired. Operating executives remain at a premium, and private equity firms continue the trends of ‘conglometising’ through shared resources groups, in-house specialty functionalities like shared purchasing, executive search, and so on.

Dinamani: Private equity houses are not particularly short of funds at the moment, but certainly there appears to be a desire from private equity houses to look at the way in which they have created value in the past by exercising their extensive knowledge on how businesses should run in order to create growth. Private equity houses are loaded with investment professionals who have this ability. It would be wrong to say that they have ignored their ability to do this in the recent past but certainly it seems that there is more interest from even the larger buyout houses to acquire relatively smaller businesses on the basis of buy-and-build strategies, or international expansion, as a way for them to add value to their investments.

Memminger: Operational expertise has been a topic for the last 5-10 years and while it is significant, its importance has not increased in the last 12-18 months, given the attractive financial and economic environment.

Putting in place clear lines of responsibility and reporting, recruiting or retaining advisers to manage that burden, and dealing with the new rules efficiently and sensibly will be seen as real positives in the eyes of investors, regulators and peers.

— Kate Downey

FW: Could you outline some of the high profile regulatory changes which have emerged following the financial crisis? In your opinion, how will compliance requirements affect the asset class in the long term?

Abelow: The old ‘wild west’ of private equity is looking increasingly like an Orange County subdivision – everyone gives lip service to the need to unleash entrepreneurial energies and the like, but all the lawns are impeccably manicured. The SEC has, courtesy of Dodd-Frank, become interested in the sector. While the ‘presence exams’ are now finished, the SEC has used them to get quite smart on the industry and is now beginning to push back on some fund housekeeping in ways both small and large. Even more important to the deal environment is the fact that banking regulators have decided to impose seemingly artificial limits on leveraged lending. The net effect of this in the middle market so far has not been to curtail lending, but to change radically the cast of characters in middle market financing.

Downey: The financial crisis presaged a tsunami of regulation which the funds industry now has to get to grips with. Most significant of these in recent years has been the EU’s AIFMD, which has significantly increased the reporting and regulatory burden on funds seeking to market and operate inside the EU, and FATCA – and its offspring – which is increasing the drive for transparency and disclosure of information to tax authorities. Both new regimes have been marked by a protracted and inconsistent implementation process across different jurisdictions. This has made it challenging for fund managers to plan and prepare effectively. Investors are also unhappy about the added costs placed on funds to provide reporting and disclosures which they had not looked for in the first place. Longer term, this rise in compliance is something which most established fund managers will take in their stride, but there is a risk that, at least in the interim, it adds to the financial and administrative burden on funds without providing the purported benefits of transparency and uniformity. Disclosure of information for its own sake is valueless unless the market, investors and regulators have the appetite, resource and tools to usefully interpret the flood of information that will follow.

Dinamani: Private equity houses cannot ignore AIFMD. For European-based managers the compliance burden is significant, and funds will start experiencing additional costs as depositaries and other service providers have to be paid. Non-European managers, particularly those which have done a fundraising since summer 2014, will be aware that the private placement regimes around Europe have tightened and reverse solicitation is only an answer in very isolated circumstances. Later this year we will see the introduction of an optional third country passport for certain non-European fund managers, but the price of that will be significant ongoing compliance that they likely will not be familiar with. It is also worth noting that, subject to ESMA’s report later this year, third country passporting and full compliance will become mandatory in 2018 for any funds worldwide that are marketed in Europe after that date. And for managers who have a strategy of radical reorganisation of their investee companies, the AIFMD private equity rules are already presenting challenges. Some firms are also grappling with AIFMD remuneration controls. Some have found that the increasing use of segregated account structures and co-investments can alleviate some of these difficulties in some cases but the AIFMD net is wide and if not done carefully and in the right circumstances still presents challenges. There are many other regulatory developments that certain private equity firms have to be on top of – from Volcker and the European Banking Consolidation Directives that affect the ability of bank-affiliated entities to sponsor funds, to the long-awaited Solvency II which affects how insurance companies, who make up a large proportion of investors in private equity funds, can invest to MiFID II, which for some firms may affect the way in which non-management fee payments are received. There is also the continuing scrutiny of so-called ‘alternative credit providers’ which is considered to include private debt funds, as regulators and policymakers carefully balance the crucial liquidity they offer to the debt markets with the need to have a clear oversight on their activities to manage systemic risk and maintain adequate investor protection. These are just a few examples.

Memminger: The major regulatory change for the industry has been the AIFMD implementation in Europe. This caused a significant need on the private equity firm’s side for adequate counselling and to incur the necessary costs to ensure AIFMD compliance. Besides the costs, this has also bound management resources and hence one hears complaints about it at every corner, in particular at the beginning where reliable regulatory guidance was missing on important topics such as the qualification of management participation pools. With the regulatory guidance that has been received in the meantime, private equity players nowadays know that they can basically continue their business model as before – although at slightly higher costs – irrespective of AIFMD. Compliance has, over the last five years, become an increasingly important topic and one typically now sees compliance due diligence when deals are reviewed. Given the stakes at hand – in terms of potential penalties – this trend will continue.

Elvin: Regulatory reforms have been a hot topic in the industry of late, as well as a source of confusion, given the uncertainty of impact, complicated laws and frequently delayed implementation dates. We asked fund managers for their opinion as to how they see regulation changing the private equity landscape in 2015. The largest proportion of fund managers surveyed – 45 percent – believe that the change will be for the worse. A number of respondents specifically stated that the increased bureaucracy heralded by new laws complicate the processes, and highlighted the fact that fund managers are under pressure from a number of regulations, not least the AIFMD, but also the Foreign Account Tax Compliance Act (FATCA) and Dodd-Frank, as well as having to stay on top of directives that will influence the investment activities of target LPs. LPs also appear to be concerned with the impact such changes may have on their investments, with 21 percent of survey respondents citing regulation as one of the biggest challenges facing investors in the year ahead.

Lavery: Clearly the most significant regulatory development since the financial crisis has been the AIFMD, not only for PE funds but for the fund industry as a whole. The Directive impacts on both managers and the underlying fund products, leading to an increase in compliance requirements and costs. The question then arises as to whether these costs are borne by the manager or passed on directly or indirectly to investors. Ultimately, AIFMD may be a positive development if being a registered AIFM becomes seen as a badge of credibility by investors not just in Europe but further afield, helping private equity fund managers attract investment from a broader range of investors. Our overall view is that the Directive probably means short term pain, and increased regulatory burden costs, but could lead to long term gain such as increased credibility and fundraising ability.

FW: What advice would you give to private equity firms that are struggling to understand and react to regulatory change?

Memminger: Seek proper legal advice. These regulatory changes increase your cost of operation, but this doesn’t mean that you cannot do business, or that you tremendously need to change the way you do business.

Lavery: The industry is still in a state of flux and a failure to comprehend the impact of regulatory change could very easily prove to be terminal for a private equity house in the current climate. For that reason alone, the advice would have to be to pause and take the time to clarify what the change might mean. Take appropriate advice and don’t brush the potential risks to one side. A private equity house’s existing and potential fund members are increasingly risk averse and will want clear answers from the private equity house on what the regulatory change means.

Abelow: If this is a revolution in affairs, it is a lawyer’s revolution. It is fundamentally procedurally-driven, and the relevant issues can be for the most part solved with enhanced processes at GPs. General partners should carefully document their processes for things like expense allocations and reimbursements. They should hire third party valuation firms to ensure the integrity of their valuation procedures. They should periodically conduct mock SEC exams to ensure that any issues are uncovered and cured quickly in the privacy of their own homes, rather than under the harsh glare of the spotlight.

Dinamani: Private equity firms need to seek advice. The rules are complex, they transition into force at different times depending on where and how your fund is marketed, and the consequences of getting it wrong could be severe. There is certainly no one-size-fits-all solution. There may also be merit in planning fundraising activity to align with the various phases of AIFMD implementation, for example making use of the third country passport for those countries where private placement regimes are impractical or non-existent. The same may be true for Solvency II implementation, although it is a little early to say. For regulatory concerns affecting a firm’s investor base, such as Solvency II, we would also strongly suggest spending time talking through with those investors how they themselves are managing the process, and aligning the firm’s own processes as appropriate.

Downey: There is a wealth of information available about the new regulatory environment which is easy to access. Many advisers and administrators are also happy to provide ‘teach-ins’ on the impact of new legislation. The other advice is ‘be realistic and be prepared’. While the rise in compliance is not always welcomed by the industry, it is nonetheless a very real part of the modern market and is here to stay. Putting in place clear lines of responsibility and reporting, recruiting or retaining advisers to manage that burden, and dealing with the new rules efficiently and sensibly will be seen as real positives in the eyes of investors, regulators and peers. This is not a trend which any asset manager can afford to ignore.

The most successful private equity fundraisings have been those managed by managers with a long term track record of investing in a particular asset class or strategy, many of which have been ‘follow on’ funds.

— Jim Lavery

FW: How has private equity fundraising fared over the last 12 months? What factors differentiate fund managers in the eyes of a prospective LP?

Abelow: As the asset class continues to mature, LPs are no longer looking for a ‘mad scientist’ genius investor, or at least not just that investor in a vacuum. They are looking for firms with well-proven playbooks for sourcing, acquiring and improving businesses. They have become interested in the language of 100-day plans and value creation levers that can be pulled time and time again across different portfolio companies. They want, in other words, in their fund managers what the GPs themselves want in their best portfolio companies: sustained competitive advantages.

Memminger: While the private equity industry has otherwise recovered in recent years to nearly pre-crisis conditions, in terms of availability of debt, its terms, pricing and deal flow, one still sees that fundraising is a challenge for some players. In the period 2009-2012, when the fundraising market basically dried up, the limited number of LPs that wanted to invest put an increasing emphasis on the track record of the general partner and its performance, which meant that even for some established players fundraising was unsuccessful, due to lack of successful deals in the years before. While fundraising has become easier now, even for first time funds, one can observe that LPs continue to put a large emphasis on the success of the GP in prior years, and whether the people that made this success happen are still with the GP. So while first time funds even at the medium market are again possible, this only applies to those players where the GP is able to show continuing success in prior positions at other firms and flexibility on the fee structure.

Dinamani: We are seeing a split into, on the one hand, large buyout funds having little difficulty in fundraising, and indeed having to scale back, with the investor relationship headaches that can bring, and on the other hand, the smaller funds struggling to get to their target commitments. Institutional investors seem to be cash-rich at the moment, in part due to private equity firms having returned considerable distributions in the last two to three years, with the result that ticket sizes are bigger and investors are targeting more funds. Against that, some investors are becoming more sophisticated and have their own teams of professionals who can handle direct deals themselves, and some investors are accordingly more demanding in their terms. Major institutional investors are also making commitments in private equity funds, and we have seen a sharp rise in the complexity of negotiated side letters, even against the backdrop of the wall of capital available for the buyout funds – showing that it is still very much a relationship-driven industry.

Elvin: 2014 was another solid year for fundraising, with a total of 1125 funds reaching a final close, raising a combined $533bn of commitments, slightly up on 2013’s 1234 funds and $531bn. The level of LP appetite has driven strong fundraising, but this has been combined with an unprecedented interest among GPs in raising new funds – as of March 2015, a total of 2203 private equity funds are on the road, seeking a combined $793bn from LPs. As a result, fundraising is as competitive and challenging as ever, and only GPs with a clearly focused and compelling proposition are likely to succeed. Thirty-seven percent of investors named past performance as one of the most important factors to take into account when seeking new private equity fund managers, though this is 3 percent less than last year’s survey results. In addition, length of track record is of key importance to 19 percent of respondents, compared with 21 percent in 2013. Other factors of importance to investors included the team and being able to build a trusting relationship with the fund manager. Evidently, in the search for unique investment opportunities, LPs are beginning to place more importance on what fund managers can offer going forward and the harmony they can achieve in the GP-LP relationship.

Downey: 2014 was another strong year for fundraising. Overall, the record levels of returns flowing back to investors during 2013, plus the ongoing scarcity of reasonably-priced deal flow has led to a marked increase in dry powder. Longer term this is likely to put a natural brake on the fundraising machine as managers struggle to deploy at a rate and at a price point which allows them to hit their target returns. Thus, whilst activity levels remain high, there is a general concern growing in the market that these themes presage a general slowdown in 2016-17. 2014 also saw the continuation of the growing divide between the ‘haves’ and the ‘have nots’, as those PE managers with a strong track record, good recent returns and robust market position raised large funds on an expedited timeline whilst many, including some established PE names, struggled to close at all. Getting capital back to LPs, and having demonstrable access to proprietary deal flow in this aggressively competitive market, have been two of the key differentiating factors of 2013-14.

Lavery: Our experience is that the private equity funds industry has continued to see a flight to quality over the last 12 months. The most successful private equity fundraisings have been those managed by managers with a long term track record of investing in a particular asset class or strategy, many of which have been ‘follow on’ funds. It is still difficult for new entrants to raise significant amounts in the market, however the last 12 months have seen a slight easing of this. We are cautiously optimistic about the prospects for new funds and managers, provided fundraising expectations are realistic.

FW: How is the relationship – and the balance of power – between general partners and limited partners affecting the fundraising process?

Dinamani: The balance of power depends on individual relationships, but overall it has shifted toward the large buyout GPs and at the same time to the smaller fund LPs. But within that there are anomalies as some investors are still able to command greater attention among the large buyout GPs, while at the same time some investors have a large number of small tickets and do not wish to negotiate any of them in any great detail, requiring just basic protections.

Downey: If anything, there has been a readjustment or rebalancing of the relationship between LPs and GPs generally in the last 24-36 months, following the significant pro-LP swing after 2008. Certainly at the ‘haves’ end of the market, those GPs which have generated momentum have been able to capitalise on the perceived scarcity of quality managers to resist ongoing erosion of terms. However, this is tempered by the significant concessions which some cornerstone or anchor LPs are demanding from those GPs that are dependent on their support for a successful fundraising, where fee-free co-invest, discounts on fees and carry and significant keyman and GP removal concessions have sometimes been required. In this year, as in so many, this part of the story is all about sovereign wealth. This all needs to be seen against a backdrop of increasing appetite for segregated mandates and separate managed accounts. Many fund managers are finding it more effective to raise a ‘platform’ of segregated mandates accommodating the different demands of core investors than to try to accommodate all of these in a ‘one size fits all’ fund structure. This has the potential to offer real benefits for LPs, who can meet their specific needs around asset appetite, duration, deployment or quasi-evergreens, and for GPs, who get a more direct and flexible relationship with each LP, scalable for future fundraisings.

Lavery: The balance of power remains firmly with investing LPs. There is a lot more negotiation around fund terms as a result and greater dialogue and discussion between cornerstone LPs and general partners, such that the fundraising process becomes an iterative one. On the whole, this is a positive development leading to the greater alignment of interests between the fund managers and the LPs.

Elvin: We asked investors that were dissatisfied with their fund terms and conditions what could be done to improve the alignment of GP and LP interests. The largest proportion – 60 percent – of respondents quoted management fees as a prominent issue. This is a further increase on the proportion of LPs that held the same opinion in December 2013 – 56 percent – which indicates that instead of more GPs addressing and correcting the problem, more investors feel that fees are unaligned. The majority – 61 percent – of investors interviewed occasionally choose not to invest in a vehicle due to the proposed fund terms and conditions, while 6 percent stated they have frequently taken the decision not to invest as a direct result of the terms and conditions – and the remaining never have. Additionally, 24 percent of the LPs that rejected funds had done so in the last six months. This indicates the importance of GPs making their fund terms and conditions appealing to potential LPs, as an increasing number of investors are willing to discard prospective investments if they are not satisfied with the returns offered.

Memminger: One can see that only those firms with an exceptional track record are still able to apply the old fee and carry model. For other firms, one can observe that LPs are more and more successful in demanding alternative fee arrangements with a reduced or even deleted management fee charged to the LPs. In addition, the demand for co-investment rights has increased in recent years.

Abelow: Sometimes this seems like asking about the balance of power between the US and the Benelux countries – the balance has sometimes seemed one-sided, especially when ‘hot’ private equity firms have been in a position to ration access to their funds. Lately, however, the LPs have managed to pool enough bargaining power – Brussels is the seat of the European Union, after all – to win some real standardisation in fund fees and some real industry-wide concessions on transaction and monitoring fees.

The LPs have managed to pool enough bargaining power to win some real standardisation in fund fees and some real industry-wide concessions on transaction and monitoring fees.

— Justin Abelow

FW: Has the reported decline in the number of private equity fund terms involving monitoring fees or transaction fees continued? Is elimination or redistribution of such fees the answer?

Downey: It is now increasingly uncommon for private fund managers to retain any portion of transaction or monitoring fees. Some lower mid-market and mid-market houses have been successful, either due to the strength of their negotiating position, or because they have been able to demonstrate clearly that such amounts are a material part of their operating budget. In the main, however, the pushback given voice by the ILPA some years ago, and heavily reinforced by recent SEC and EU sanction, is eroding these types of fees as a feature of deals. The increasingly competitive deal market has also proven a factor here – incumbent management teams dislike these sorts of fees, so funds may have to sacrifice them to remain the preferred bidder.

Elvin: Fund managers typically provide their portfolio companies with a number of services for which they can charge a fee. Transaction fees, among others, can be of significant value, often amounting to 1 to 1.5 percent of the value of the companies acquired. Although at one time it was common practice for GPs to retain the entirety of these fees, it is becoming more common now for funds to rebate all, or a certain proportion, of these fees to their LPs through a reduction in the management fee. Vintage years 2011 to 2013 have a median of 100 percent of fees rebated, with the most recent vintage funds at a median level of 80 percent. The highest mean for buyout funds was seen in 2012 with an average of 92 percent of transaction fees rebated to the LP. This fluctuating trend suggests unsteady shifts in the power balance between GPs and LPs, which has been changeable over the past few years, influenced by the challenging conditions of the fundraising environment.

Memminger: Whether the elimination or redistribution of such fees is the answer depends on whether the GP is willing to accept that a significant income stream of the past will vanish in the future. One has to keep in mind that the loss of this income stream is not offset by more favourable carry arrangements – some players are able to do this, but the vast majority cannot – and the GP has to finance its ongoing operations, which is the original purpose of the yearly management fee. The market, and more precisely the ever shifting power between GPs and LPs, will answer that question. LPs are less concerned if management fees are charged to a portfolio company than if they have to finance it upfront, even in cases where no deal has been done by the GP.

Abelow: It will be interesting to see if the decline in fees is the result – perverse, perhaps from the LP’s standpoint – of increasing the relevant market clout of the larger PE firms who might be, at least on some measures, less dependent on these fees.

Dinamani: In our experience fees have not continued to decline. There are good commercial reasons for charging investee companies a fee for deal advice and assistance, and in our experience those fees are almost always offset against management fees at the fund level, or used to meet abort costs within the fund. Overall, this should be positive for fund cashflows and for the overall efficiency of the fund holding structure, and we haven’t seen a lot of pressure on that model. What we are seeing is greater scrutiny on the ability of SPV boards to make proper decisions, and the tax consequences if they are not, and that is leading managers to reassess their investment holding structures in some cases. We expect this to be a significant continuing theme but not necessarily to change the transaction fee dynamic.

Lavery: In seeking to align the risks and rewards between fund managers and investors, and in particular where the fund bears the downside risks of, for example, abortive investments, we are seeing pressure from investors that these types of fees are set off against the annual management charge. There will always be an element of bargaining power applied here, with the funds that have been most successful over a medium to long term better able to manage investor demands. We would note that for smaller funds and fund managers, monitoring and transaction fees remain an important way of generating income pending receipt of carried interest. Investors recognise this and so there is less pressure on these at this end of the market.

Private equity continues to sit on record levels of dry powder and debt remains available, both leveraged and high yield. Pricing expectations for good quality assets remain high and strategic buyers remain active in Europe.

— Karan Dinamani

FW: What do you expect to see in the private equity industry over the coming months? Does 2015 offer any key opportunities and challenges for private equity firms?

Memminger: Thepositive momentum will continue. While we still have a number of political uncertainties in Europe, it seems that the market, with its vast availability of debt financing at attractive terms, is not worried too much – hence circumstances will not significantly impact the positive outlook for 2015. But if the pricing of assets continues to rise, private equity players may want to wait on the sidelines until pricing has come back to more normal levels.

Lavery: Liquidity in the debt market and competition between credit providers will mean that debt multiples will increase but not dramatically as a borrower’s ability to service debt will be the limiting factor. This, alongside the increased flexibility in debt structuring, especially the use of unitranche and second lien structures, ought to enable private equity houses to look at paying higher multiples for businesses. With this greater liquidity will come the risk of overheating, and that has to be acknowledged and continually assessed. There are likely to be more secondary and tertiary buyouts than we have seen in the last couple of years. Also, expect sector specialisation to become a prominent theme.

Abelow: PE firms will continue to specialise around industries and specific transaction types. Private equity portfolio holding periods are becoming more variable, and there will be some remarkably quick flips of acquired companies over the coming months. Not coincidentally, the traditional LP model will come under more stress. The secondary and primary PE markets will continue to converge, with sometimes unanticipated results.

Elvin: 2014 has been a successful year for the private equity and venture capital asset class and with healthy market conditions, cash-rich fund managers and generally content investors, 2015 has the potential to follow suit. However, significant challenges face both GPs and LPs. While investors will be enjoying the liquidity delivered to them by ongoing high levels of distributions, the market is saturated with a record number of funds seeking capital, and investors consequently face the challenge of identifying the best investment opportunities. On the other hand, fund managers are confronted with intense competition, not only with fundraising, but also in finding attractive deal entry prices while at the same time having to meet increased demands from both investors and regulatory bodies.

Dinamani: Private equity continues to sit on record levels of dry powder and debt remains available, both leveraged and high yield. Pricing expectations for good quality assets remain high and strategic buyers remain active in Europe. Various macroeconomic factors add uncertainty to the debt and deal environment – particularly the depressed oil price, uncertainty around the future of the eurozone, Europe’s relationship with Russia and, for the UK, the outcome of the general elections in May. Informal soundings taken from investment professionals indicate that 2014’s discipline of not involving themselves in auction processes will continue, unless there is a real angle allowing private equity to compete on price against well-funded strategic buyers. That said, private equity is in the business of making acquisitions and we are expecting private equity houses to increase their deal flow by seeking to obtain value by focusing on more complex bilateral transactions – whether that is looking at smaller transactions with a view to effecting a buy-and-build strategy, looking at carve-outs, or identifying assets with talented but under-supported management teams – all tactics which have delivered significant returns to private equity in previous decades.

Downey: With return rates under pressure, investors are looking to managers for security of pipeline, creativity and flexibility of mandate as we head into the second half of 2015. This will fuel the ongoing rise of bespoke LP mandates which will continue into 2016 and looks likely to become an increasingly significant part of the funds market in coming years. We expect credit and venture funds to continue to see increased investor allocation over this coming year, as well as more room given to special situations funds – the ‘anything, anywhere, anytime’ model – an interesting counterpoint to the concerns about strategy drift which dominated the more conservative markets of 2009-2012. The gradual opening up of the DC-pension plan market in the US and the rise in products targeting the retail market also looks likely to open up substantial and previously untapped sources of global capital for fund managers who can navigate the legal and regulatory hurdles. As new regulation beds down in both Europe and the US, we will also continue to see the ratcheting up of pressure on the use of offshore jurisdictions and perceived tax havens, such as Luxembourg. The market is healthy and opportunities significant, but the challenges are equally so. Successful managers need to continue to focus on ways to differentiate themselves in an increasingly saturated market, both when fundraising and investing.

Karan Dinamani is a partner in Allen & Overy LLP’s private equity M&A team. He has extensive experience advising private equity houses on acquisitions and disposals and also advises corporates and investment banks on the full range of cross-border M&A and corporate finance transactions. Mr Dinamani has been named as one of the 40 under 40 rising stars in legal services by Financial News. He can be contacted on +44 (0)20 3088 3254 or by email: karan.dinamani@allenovery.com.

Jim Lavery is a partner at DLA Piper. Mr Lavery advises on corporate finance transactions, particularly mergers and acquisitions and private equity both nationally and internationally. He has particular experience in the aerospace, oil & gas and medical devices sectors. He can be contacted on +44 (0)121 262 5663 or by email: jim.lavery@dlapiper.com.

Justin Abelow is a managing director in Houlihan Lokey’s Financial Sponsors Group, focusing on private equity coverage in the US and Europe. Before joining Houlihan Lokey, he worked as a managing director at Deutsche Bank and as a vice president at J.P. Morgan. Over the course of his career, Mr Abelow has worked on more than 300 closed transactions involving more than 40 discrete private equity firms. He can be contacted on +1 (212) 497 4206 or by email: jabelow@hl.com.

Kate Downey is a private funds partner in the London office of Kirkland & Ellis International LLP. Ms Downey advises fund sponsors and financial institutions across a broad range of asset classes, including private equity, venture and growth, infrastructure, credit and real estate. She also counsels fund managers on carried interest, co-investment and other incentive arrangements, including leveraged co-investment arrangements and has considerable experience of a broad range of other international private equity transactions. She can be contacted on +44 (0)20 7469 2214 or by email: kate.downey@kirkland.com.

Christopher Elvin joined Preqin in 2006, and is currently head of Preqin’s private equity products and responsible for Preqin's market leading online products and solutions. Having spent many years in senior positions across the sales team, he is now in charge of defining Preqin’s strategic direction in the private equity industry, both through innovations to Preqin’s online products as well as through Preqin’s research and communications strategy in this space. He can be contacted on +44 (0)20 3207 0256 or by email: celvin@preqin.com.

Dr Peter Memminger is a partner in the Frankfurt office of Milbank, Tweed, Hadley and McCloy LLP. He specialises in mergers & acquisitions (including distressed situations) and public takeovers, with a particular focus on private equity transactions. He is also involved in outsourcing transactions. His recent transactions include the public takeover of Germany-based W.E.T. Automotive Systems AG by US-based Amerigon Inc. Dr Memminger is a regular lecturer and commentator on M&A related topics. He can be contacted on +49 69 719 143 453 or by email: pmemminger@milbank.com.